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During a news talk show on August 14, 2011, Princeton University economist and 2008 Nobel Prize winner Paul Krugman made a startling declaration: If the United States were to mobilize for a supposed invasion of “space aliens,” the current economic downturn would be over “in 18 months.” The CNN interviewer did not laugh at this assertion, nor did Harvard economist Kenneth Rogoff, who also was a guest on the show. (Rogoff did not directly endorse Krugman’s scheme of preparing for invasion, but he did say that the economy needed much more inflation than it currently has.)

Most people would scoff at the notion that a government could bring about an end to mass unemployment and economic stagnation by preparing for an imaginary invasion of “space aliens,” but Krugman was dead serious. Now, serious people might wonder why the nation’s most elite academic economists would claim such a thing as a “cure” for economic malaise, but they were saying things consistent with Keynesian economic theory, the theory that for now rules academe and determines policy for the world’s central banks.

At this writing, the economy of the United States — and, indeed, most of the industrialized world — is in deep recession. Millions of people are out of work and cannot find employment (or must settle for part-time work or even work “off the books”), and while the nation’s official rate of unemployment might even fall here and there by tiny amounts, nonetheless the once-mighty U.S. economy is moribund, and everyone knows it.

When the collapse of the housing bubble began in earnest in 2007, the government’s response, first under George W. Bush and then under Barack Obama, has been to ramp up federal spending. Despite Krugman’s many assertions in his column in the New York Times and elsewhere that government spending has not increased in any appreciable terms, in fact federal-government spending in the past five years has gone up by about a trillion dollars, according to the U.S. Department of the Treasury.

The increase in spending has been deliberate and even has economic theory behind it, thus justifying the existing proclivity of politicians to spend the money of others whenever it is deemed politically “necessary.” Whether or not this theory developed by John Maynard Keynes more than 70 years ago is a good one and whether the massive increase in spending is helping the economy or retarding its growth is another matter, and in this article, I argue it is retarding it. At the present time, however, people who believe that sound economic theory is incompatible with the government’s current course are in a distinct minority.

While politicians really need no theoretical reason to clamor for more spending for favored and connected interest groups, nonetheless the theories of Keynes, made famous during the 1930s, provide the fig leaf for governments to claim that their wild spending habits actually reflect responsible behavior. Whether it is the Greek government borrowing billions of dollars to finance its payments on previous debt or the U.S. government ramping up its debt to more than $15 trillion, all can claim that they simply are doing what Keynes told them to do: spend when the economy tumbles into recession.

Many politicians and academic economists claim that those who oppose the Keynesian view are wrong simply because they are a relatively small number. The critics argue that if those who disapprove of the current spending regime cannot persuade the majority of politicians and economists to agree with them, then that alone proves they are wrong.

One cannot argue against that kind of “logic” precisely because it is not logic at all, but rather the logical fallacy of ad populam, or a form of “everyone knows it to be true.” (One saw this form of argument during the Republican presidential debates when the candidates claimed that Ron Paul’s view of the 9/11 attacks — that Muslim Arabs were reacting against the United States’s heavy-handed foreign policy and did not attack it “for our freedoms” — was false on its face. Never once have I seen them offer a shred of evidence otherwise other than to say that Paul’s arguments are wrong because … they are wrong.)

That being said, proponents of the viewpoint that increasing government spending during a recession hurts rather than helps the economy must overcome what would seem to be popular wisdom as well as get their point across to a world that really does not seem to want to hear what they say. Matt Yglesias recently wrote in an article in Slate that such a viewpoint really amounts to little more than a philosophy of despair and helplessness. With that perception (a false perception, to be sure) attached as unwanted baggage, people pursuing our reasoning must be prepared to explain everything with the understanding that even the clearest explanation is going to be rejected by others.

Ours was not the minority point of view, at least in the 19th and early 20th centuries. When faced with a massive financial panic and recession in 1837, Martin Van Buren declared he had neither constitutional authority nor sound economic doctrine for government to ramp up spending. More than 80 years later, Warren G. Harding told conferees who met to discuss potential government action during the Panic of 1921 that the best thing the government could do was … nothing.

How, then, did the intellectual and political forces change in the way that governments, and especially the federal government, dealt with economic downturns? How is it that the policies changed essentially from laissez faire to massive government intervention, and why is it that those who once were seen as intellectually correct are now publicly regarded as villains? And how did economic theory, which once recommended a laissez-faire approach to dealing with economic downturns, turn into a mechanism that supports irresponsible behavior on behalf of national governments? We must look to history for the answers.

Competing theories on economic downturns

Long before there was an Austrian school of economics and long before John Maynard Keynes wrote his terribly influential General Theory in the 1930s, there were the arguments between the followers of Thomas Malthus and those of Jean-Baptiste Say. Malthus, a British clergyman who is more famous for his writings on population growth than economic demand (he said that population growth would outstrip the world’s food supply, bringing on mass starvation), wrote that an economy is under the constant danger that people will stop spending money and, thus, leave a “glut” of commodities. (It should be noted that even Malthus’s ideas on “overproduction” or “underconsumption” were not new. Bernard Mandeville in his early 18th-century poem, “The Fable of the Bees,” had said many of the same things, claiming that what would seem to be “private vices” — spending all of one’s income and failing to save — were “publick virtues.”)

The presence of the “glut” would set off a chain reaction beginning with an increase in unemployment, as business owners would lay off workers because of the lack of demand for their products. Those workers then would lose their purchasing power, decreasing demand even further, until the economy went into crisis. Thus, the very productive power of the economy would prove to be its undoing, as producers would create more goods than could be sold, causing “general gluts” in the market and further depressing it.

Classical economists such as Say, David Ricardo, and later John Stuart Mill, however, argued that production itself was the source of “purchasing power,” not money. Unlike Malthus, who held that production and consumption were two separate and unrelated entities, Ricardo, Say, and their followers noted that the purposeful end of production was consumption. There was no causality in Malthus’s argument, they noted, and no reason that people would just choose arbitrarily to stop consuming the goods they had produced.

Furthermore, Say argued, if there were a “glut” of commodities on the market, the glut would be “proportional,” not general in that it would be impossible for there to be a general overproduction of goods. Instead, Say wrote that some goods might be temporarily overproduced for market demand, but at the same time, other goods would be “underproduced,” and over time the economy would find its balance.

Interesting enough, the classical economists fully accepted Malthus’s theories on population (leading to Ricardo’s “Iron Law of Wages” in which wages always would fall to subsistence), but they rejected Malthus’s views of “overproduction.” Events have discredited the former viewpoint, and they should have discredited the latter, but modern intellectuals in the end still embrace Malthusian population theory and have formalized his theory of why economic downturns exist.

In the mid 1800s, Karl Marx further systematized the Malthusian theory of business downturns, but with a new twist: he argued that the presence of profit that went to the capitalists was an “unjust expropriation” of the wages of labor and it deprived workers of the “purchasing power” that would permit them to “buy back” the goods they had produced. Nonetheless, the result was the same, that being a “general glut” of products, which ultimately would drive down the economy. In the Marxian view, the systematic “expropriation” of the wages of laborers would lead to crisis, as the glut of products would result in layoffs and mass unemployment, which would be the tinder that would spark revolution and ultimately the utopia of communism.

None of the theories that have appeared so far could be labeled “business cycle” theories, although they laid building blocks for them. Certainly, many intellectuals (although not many economists) embraced Marx’s views, and Marx gave them ammunition against capitalism, as it not only was predatory but also sowed the seeds of its own demise.

Part 1 | Part 2 | Part 3

This article originally appeared in the June 2012 edition of Future of Freedom. Subscribe to the print or email version of The Future of Freedom Foundation’s monthly journal, Future of Freedom (previously called Freedom Daily).

Reading List

Prepared by Richard M. Ebeling

Austrian economics is a distinctive approach to the discipline of economics that analyzes market forces without ever losing sight of the logic of individual human action. Two of the major Austrian economists in the 20th century have been Friedrich A. Hayek, who won the Nobel Prize in Economics, and Ludwig von Mises. Posted below is an Austrian Economics reading list prepared by Richard M. Ebeling, economics professor at Northwood University in Midland and former president of the Foundation for Economic Education and vice president of academic affairs at FFF.